Nepal’s financial system poses a striking paradox: Banks are oversupplied with money, but the real economy is struggling to get credit. By the first quarter of this fiscal year, banks had over Rs1.1 trillion in loanable funds: One of the biggest surpluses in Nepal’s history. Monthly remittances above Rs200 billion have further inflated deposits. But despite the surplus, the credit-deposit ratio has hovered at around 74 percent, industries continue to operate way below capacity, interest rates have slumped to a four-year low, and households and businesses remain extremely wary of borrowing. This contradiction highlights deeper issues in the structure and direction of Nepal’s economy. Structural treatment is now pressing action.

One of the main reasons for such a situation is the extremely high and volatile interest rates, at times as high as 20 percent, imposed by banks since the Covid-19 pandemic. These interest rate shocks drastically eroded public confidence and discouraged generations of borrowers from investing. If firms, households and entrepreneurs lose confidence in the system, then even affordable credit cannot induce them to take risks. Weak regulations, corruption and illogical policies on the part of central banks were other contributing factors that made the environment so insecure that neither banks nor businesses are confident enough to invest in long-term projects.

Interest rates cannot revive an economy if its structural foundations are weak. When China encountered inflation of around 25 percent in the early 1980s, it refused to drastically raise interest rates as practised by the central banks of the West. It instead used supportive fiscal and industrial policies to maintain business competitiveness and confidence. China continued to grow at double-digit rates despite predictions of an economic failure by Western economists. The example shows that monetary tightening is not always the right solution for developing economies, particularly those suffering from structural bottlenecks like Nepal.

Nepal exhibits classic symptoms of a liquidity trap, a situation wherein lower interest rates fail to spur borrowing because people lack confidence in the economic environment. True, Nepal Rastra Bank (NRB) has made policy adjustments by cutting policy rates, easing rules for availing overdraft, relaxing deposit restrictions and tweaking liquidity management instruments. However, these measures do not remove the deeper structural constraints that prevent money from flowing into productive investment. For the economy, the cost of money is not the core challenge; it is a shortage of strong, high-quality, bankable projects that can absorb liquidity in the financial system.

Nepal’s liquidity paradox can be explained from the perspective of New Structural Economics (NSE), developed by Justin Yifu Lin, former World Bank Chief Economist. NSE articulates that monetary policy in developing economies needs to be judiciously aligned with their stages of structural transformation. In countries with abundant labour and underutilised productive sectors, such as Nepal, monetary policy should be development-supportive rather than merely a reaction to business cycles. The failure of liquidity to translate into investment signals bottlenecks in infrastructure, logistics and energy supply, along with market coordination. When interest rates are low, but investment remains stagnant, the real issue is insufficient structural transformation, not a shortage of money.

Coordination failures are at the root of Nepal’s credit stagnation. Entrepreneurs struggle to fund promising projects such as cold-chain systems, tourism infrastructure, hydropower corridors and Information & Communication Technology parks. On their part, the commercial banks find it difficult to appraise the financial risks of these new ventures due to information gaps, poor project preparation and scarce technical capacity. In turn, lenders and borrowers alike ‘wait and see’, in a self-reinforcing cycle that further bogs down economic momentum. Lowering interest rates alone cannot resolve these problems. Nepal needs a targeted, risk-reducing approach that guides liquidity into high-return sectors.

International experience offers valuable lessons. Over the last four decades, China has developed a developmental monetary policy that actively guided liquidity towards productive sectors. Beginning in the 1980s, the People’s Bank of China used ‘window guidance’ to direct credit towards export zones and township industries. In the 1990s, ahead of the World Trade Organisation (WTO) accession, China pushed more liquidity into industrial clusters and special economic zones. After the 2008 global financial crisis, the central bank introduced large-scale re-lending and re-discount programmes to support SMEs, agriculture, logistics and infrastructure. The 2014 Targeted Medium-Term Lending Facility (TMLF) funnelled more than RMB one trillion into cold chains, renewable energy, transmission lines and high-tech hubs.

Similarly, South Korea’s use of export-linked refinancing for shipbuilding, electronics, automobiles and steel enabled companies such as Hyundai, Samsung and POSCO to rise from small firms to global giants. Singapore used government risk-sharing schemes and blended financing to expand lending to SMEs and develop world-class logistics, tourism and digital infrastructure. These examples suggest that liquidity becomes productive only when central banks provide a strategic direction, reduce risks and coordinate with other government institutions.

Nepal can adopt similar strategies. NRB can create sector-specific refinancing windows for agro-processing, cold-chain logistics, hydropower transmission, ICT parks and tourism infrastructure. Lifting industries strongly aligned with the country’s comparative advantages pose no risk because they remain viable. These windows must use concessional loans with clear guidelines and government distinct assurance of the regional and global value chain. Nepal can also mobilise its large remittance inflows of over Rs1 trillion annually through remittance infrastructure bonds, hydro-diaspora funds and co-investment platforms that channel migrant savings into national development.

The structural roots of Nepal’s liquidity crisis are thus becoming clearer by the day. Remittances have increased deposits but weakened domestic entrepreneurship as millions of young people continue to migrate abroad in search of work. Persistent underspending in public infrastructure has denied the economy the momentum it needs to attract private investment. Political instability and regulatory uncertainty create risk aversion among banks and businesses. Limited information on potential investment prevents promising ideas from turning into bankable projects.

Overcoming these challenges requires Nepal to adopt a liquidity-to-development strategy. This would involve expediting public capital spending, preparing the pipeline of ready-to-implement projects, strengthening national credit guarantees, mobilising investment from its diaspora and guiding liquidity towards high-return productive sectors. Most importantly, NRB must expand its mandate beyond stability and take on a development-oriented role through targeted refinancing, risk-sharing and close coordination with the Ministry of Finance and provincial governments. This is not a move back to politically driven credit allocation but about correcting market failures that keep Nepal trapped in low productivity, weak exports and slow growth.